A Revenue-raising Government Taxing a Firm with Private Information

Abstract

This paper examines, for a two-period signalling game played by a revenue-raising government and a monopolistic firm in an asymmetric information context, how the government behaves when it taxes the firm’s production. Information regarding the firm’s efficiency (or its potential to pay taxes) is private; therefore, only the firm knows its ‘type’. To prevent opportunism and lead the firm to disclose information through its period-1 output, the period-1 per-unit tax needs to be lower than it would if information were perfect (and tax revenue is consequently lower). As a result, expected taxes increase with time. This behaviour generally (but not always) reduces social welfare. In contrast, when the government prefers the firm’s information is not disclosed by the period-1 signal, the expected per-unit tax in such period is the same as it would be if information were perfect. Moreover, if the firm reveals no information, then welfare is generally (but not always) greater than it would be if information were perfect. The government would generally prefer information not to be revealed, because disclose would greatly reduce its period-1 tax income. From a social standpoint, information non-disclosure increases welfare, except when both the probability of the firm being efficient and its efficiency level relative to that of the inefficient firm are sufficiently high. Clasificacion JEL: H21, D82.